The following management's discussion and analysis should be read together with theConsolidated Financial Statements of Tarrant Apparel Group and the "Notes toConsolidated Financial Statements" included elsewhere in this Form 10-Q. Thisdiscussion summarizes the significant factors affecting the consolidated operatingresults, financial condition and liquidity and cash flows of Tarrant Apparel Group forthe quarterly periods and year to date ended September 30, 2008 and 2007. Except forhistorical information, the matters discussed in this management's discussion andanalysis of financial condition and results of operations are forward looking statements that involve risks and uncertainties and are based upon judgments concerning variousfactors that are beyond our control. See "Item 1A. Risk Factors" in Part II of this Form 10-Q.

Business Overview and Recent Developments

We are a design and sourcing company for private label and private brand casual apparelserving mass merchandisers, department stores, branded wholesalers and specialty chains located primarily in the United States. Our major customers include retailers, such asMacy's Merchandising Group, Chico's, New York & Co., Mothers Work, Wal-Mart, and the Avenue, as well as wholesalers such as Seven Licensing. Our productsare manufactured in a variety of woven and knit fabrications and include jeans wear,casual pants, shorts, skirts, dresses, t-shirts, blouses, shirts and other tops andjackets. Our private brands include American Rag Cie and American Star.

Private Label

Private label business has been our core competency for over twenty years, and involves aone-to-one relationship with a large, centrally controlled retailer with whom we candevelop product lines that fit with the characteristics of their particular customer.Private label sales in the first nine months of 2008 were $123.2 million compared to $154.3 million in the first nine months of 2007.

Private Brands

We launched our private brands initiative in 2003, pursuant to which we acquire ownership ofor license rights to a brand name and sell apparel products under this brand, generallyto a single retail company within a geographic region. Private brands sales in the firstnine months of 2008 were $34.6 million compared to $32.1 million in the first nine monthsof 2007. During the first nine months of 2008, we sold apparel under the following private brands:

º American Rag Cie: Pursuant to our agreement with Macy's Merchandising Group, which extends through 2014, we exclusively distribute our American Rag Cie brand through Macy's Merchandising Group's national Department Store organization of more than 600 stores. Net sales of American Rag Cie branded apparel totaled $33.8 million in the first nine months of 2008 compared to $31.6 million in the first nine months of 2007.
º Marisa K: Net sales totaled $1.1 million in the first nine months of 2008 compared to $650,000 in the first nine months of 2007. The sale of this brand was discontinued in the second quarter of 2008.
º American Star: This brand is currently sold to Mothers' Work. Sales in the first nine months of 2008 were insignificant.

Acquisition Proposal

On April 25, 2008, Gerard Guez and Todd Kay, our founders, executive officers and directors, announced to our Board of Directors their intention to acquire all of the outstanding publicly held shares of our common stock for $0.80 per share in cash in a going private transaction. In connection with the proposed acquisition, our Board of Directors has formed a special committee of the Board to consider the acquisition proposal. The Special Committee is comprised of Mitchell Simbal and Joseph Mizrachi, who serve as Co-Chairmen of the committee, and Milton Koffman and Simon Mani. The Special Committee continues to evaluate the acquisition proposal in consultation with its own legal counsel and investment bankers.

Bankruptcy of Mervyn's LLC

On July 16, 2008, we stopped all shipments to Mervyn's LLC and made a demand under the California Uniform Commercial Code for the return of goods totaling $1.3 million which we had shipped in the previous ten days. On July 29, 2008, Mervyn's filed for bankruptcy protection. We collected $600,000 on our demand under the California Uniform Commercial Code. On August 8, 2008, we recommenced shipping to Mervyn's, under a much shorter credit term, goods that were produced for Mervyn's prior to the bankruptcy action. We have received substantially all payments for all goods shipped to Mervyn's subsequent to August 8, 2008 under the new agreed upon payment arrangement. As of September 30, 2008, we had outstanding receivables of approximately $2.8 million. We recorded a general allowance for returns and discounts of $0.3 million and an additional allowance for bad debts of $2.0 million as of September 30, 2008 taking into account further receipts of $0.5 million from Mervyn's subsequent to September 30, 2008.

Since Mervyn's bankruptcy filing, sales to Mervyn's have decreased significantly. Mervyn's was the most important customer of our FR TCL-Chazzz/MGI division, representing approximately 22% and 42% of sales of this division in the first six months of 2008 and 2007, respectively. As a result of the bankruptcy filing, we immediately performed an assessment of the goodwill relating to this division pursuant to SFAS 142. Having taken the two step analysis required by SFAS 142, we concluded that due to the Mervyn's bankruptcy filing and the significant reduction of business from another retail customer serviced by the FR TCL-Chazzz/MGI division, the fair value of the reporting unit was less than the carrying value and we therefore recorded an impairment charge to goodwill of $5.3 million at June 30, 2008. See Notes 9 of the "Notes to Consolidated Financial Statements."

Nasdaq Deficiency Notice

On October 21, 2008, we received written notification that Nasdaq has suspended its bid price and market value of publicly held shares requirements for continued listing on the exchange through Friday, January 16, 2009. On April 2, 2008, we were initially notified by The Nasdaq Stock Market that we were not in compliance with Nasdaq Marketplace Rule 4450(a)(5) because shares of our common stock had closed at a per share bid price of less than $1.00 for 30 consecutive business days. In accordance with Marketplace Rule 4450(e)(2), we were provided with 180 calendar days to regain compliance. We held a special meeting of shareholders on September 4, 2008 and obtained shareholders'approval to a reverse stock split, which may be implemented by our board of directors with a range of 1-for-1.5 to 1-for-4 if necessary to assist with regaining compliance with the Nasdaq minimum bid price requirement. On October 2, 2008, we received a Nasdaq Staff Determination Letter indicating that we had failed to regain compliance with the $1.00 minimum bid price requirement for continued listing and that our securities were therefore subject to delisting from The Nasdaq Global Market. On October 3, 2008, we requested a written hearing before a Nasdaq Listing Qualifications Panel to review the Staff's determination. The hearing, which was scheduled for November 20, 2008, has been cancelled. Nasdaq will not take any action through January 16, 2009 to delist our shares for the bid price deficiency. If we are still deficient in bid price at the close of business on January 16, 2009, Nasdaq will contact us to reschedule a hearing before a Nasdaq Listing Qualifications Panel.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. We are required to make assumptions about matters, which are highly uncertain at the time of the estimate. Different estimates we could reasonably have used or changes in the estimates that are reasonably likely to occur could have a material effect on our financial condition or result of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. On an ongoing basis, we evaluate estimates, including those related to allowance for returns, discounts and bad debts, inventory, notes receivable - related parties reserve, valuation of long-lived and intangible assets and goodwill, accrued expenses, income taxes, stock options valuation, contingencies and litigation. We base our estimates on historical experience and on various assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged period of time.

We believe our financial statements are fairly stated in accordance with generally accepted accounting principles in the United States of America and provide a meaningful presentation of our financial condition and results of operations.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. For a further discussion on the application of these and other accounting policies, see Note 1 of the "Notes to Consolidated Financial Statements" included in our Annual Report on Form 10-K for the year ended December 31, 2007.

Accounts Receivable - Allowance for Returns, Discounts and Bad Debts

We evaluate the collectibility of accounts receivable and chargebacks (disputes from the customer) based upon a combination of factors. In circumstances where we are aware of a specific customer's inability to meet its financial obligations (such as in the case of bankruptcy filings or substantial downgrading of credit sources), a specific reserve for bad debts is taken against amounts due to reduce the net recognized receivable to the amount reasonably expected to be collected. For all other customers, we recognize reserves for bad debts and chargebacks based on our historical collection experience. If our collection experience deteriorates (for example, due to an unexpected material adverse change in a major customer's ability to meet its financial obligations to us), the estimates of the recoverability of amounts due us could be reduced by a material amount.

As of September 30, 2008, the balance in the allowance for returns, discounts and bad debts was $3.6 million. It included an additional allowance for bad debts of $2.0 million related to the Mervyn's receivable. See Notes 9 of the "Notes to Consolidated Financial Statements" regarding bankruptcy filing of Mervyn's LLC.

Inventory

Our inventories are valued at the lower of cost (first-in, first-out) or market. Under certain market conditions, we use estimates and judgments regarding the valuation of inventory to properly value inventory. Inventory adjustments are made for the difference between the cost of the inventory and the estimated market value and charged to operations in the period in which the facts that give rise to the adjustments become known.

Valuation of Long-lived and Intangible Assets and Goodwill

We have adopted Statement of Financial Accounting Standards No. 142, "Goodwill andOther Intangible Assets." We assess the need for impairment of identifiableintangibles, long-lived assets and goodwill with a fair-value-based test on an annualbasis or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Factors considered important that could trigger an impairment review include, but are notlimited to, the following:

º a significant underperformance relative to expected historical or projected future operating results;
º a significant change in the manner of the use of the acquired asset or the strategy for the overall business; or
º a significant negative industry or economic trend.

Impairment of Goodwill

Goodwill in the accompanying consolidated balance sheets represents the "excess of costs over fair value of net assets acquired in previous business combination". SFAS No. 142, "Goodwill and Other Intangible Assets," requires that goodwill and other intangibles be tested for impairment using a two-step process. The first step is to determine the fair value of the reporting unit, which may be calculated using a discounted cash flow methodology, and compare this value to its carrying value. If the fair value exceeds the carrying value, no further work is required and no impairment loss would be recognized. The second step is an allocation of the fair value of the reporting unit to all of the reporting unit's assets and liabilities under a hypothetical purchase price allocation.

On July 29, 2008, Mervyn's LLC filed for bankruptcy protection, after which sales to Mervyn's have decreased significantly. Mervyn's was the most important customer of our FR TCL-Chazzz/MGI division, representing approximately 22% and 42% of sales of this division in the first six months of 2008 and 2007, respectively. As a result of the bankruptcy filing, we immediately performed an assessment of the goodwill relating to this division pursuant to SFAS 142. Having taken the two step analysis outlined above, we concluded that due to the Mervyn's bankruptcy filing and the significant reduction of business from another retail customer serviced by the FR TCL-Chazzz/MGI division, the fair value of the reporting unit was less than the carrying value and we therefore recorded an impairment charge to goodwill of $5.3 million in the second quarter of 2008.

Revenue Recognition

Revenue is recognized at the point of shipment for all merchandise sold based on FOB shipping point. For merchandise shipped on landed duty paid (or "LDP") terms, revenue is recognized at the point of either leaving Customs for direct shipments or at the point of leaving our warehouse where title is transferred, net of an estimate of returned merchandise and discounts. Customers are allowed the rights of return or non-acceptance only upon receipt of damaged products or goods with quality different from shipment samples. We do not undertake any after-sale warranty or any form of price protection.

We often arrange, on behalf of manufacturers, for the purchase of fabric from a single supplier. We have the fabric shipped directly to the cutting factory and invoice the factory for the fabric. Generally, the factories pay us for the fabric with offsets against the price of the finished goods.

Stock-Based Compensation

On January 1, 2006, we adopted SFAS No. 123 (revised 2004), "Share-Based Payment," ("SFAS No. 123(R)") which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS No. 123(R) supersedes our previous accounting under Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees" for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin ("SAB") No. 107 relating to SFAS No. 123(R). We have applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R).

Income Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for book and tax purposes. These timing differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. We record a valuation allowance to reduce our net deferred tax assets to the amount that is more likely than not to be realized. We have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance. Increases in the valuation allowance result in additional expense to be reflected within the tax provision in the consolidated statement of operations.

In addition, accruals are also estimated for audits regarding U.S. tax issues based on our estimate of whether, and the extent to which, additional taxes will be due. We routinely monitor the potential impact of these situations and believe that amounts are properly accrued for. If we ultimately determine that payment of these amounts is unnecessary, we will reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer necessary. We will record an additional charge in our provision for taxes in any period we determine that the original estimate of a tax liability is less than we expect the ultimate assessment to be.

In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109". FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes". FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return that results in a tax benefit. Additionally, FIN 48 provides guidance on de-recognition, income statement classification of interest and penalties, accounting in interim periods, disclosure, and transition. We adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, we recognized no material adjustment for unrecognized tax benefits but reduced retained earnings as of January 1, 2007 by approximately $1 million attributable to penalties accrued as a component of income tax payable. As of the date of adoption, our unrecognized tax benefits totaled approximately $8.9 million.

We and our subsidiaries file income tax returns in the U.S., Hong Kong, Luxembourg, Mexico and various state jurisdictions. We are currently subject to an audit by the State of New York for the years 2003 to 2005, but are not currently being audited by other states or subject to non-U.S. income tax jurisdictions for years open in those taxing jurisdictions.

In January 2004, the IRS completed its examination of our Federal income tax returns for the years ended December 31, 1996 through 2001. The IRS had proposed adjustments to increase our income tax payable for these years under examination. In addition, in July 2004, the IRS initiated an examination of our Federal income tax return for the year ended December 31, 2002. In December 2007, we received a final assessment from the IRS of $7.4 million for the years ended December 31, 1996 through 2002, and in the first quarter of 2008, we entered into a final settlement agreement with the IRS. Under the settlement, which totals $13.9 million, including $6.5 million of interest, we agreed to pay the IRS $4 million in March 2008 and an additional $250,000 per month until repayment in full. The settlement with the IRS is within amounts accrued for as of December 31, 2007 in our financial statements, and we therefore do not anticipate the settlement to result in any additional charges to income other than interest and penalties on the outstanding balance. Due to the negotiated settlement, we reclassified the IRS and state tax liabilities from uncertain tax position to current payable on December 31, 2007. In March 2008, we paid the IRS $4 million in accordance with the settlement terms. Due to the installment agreement with the IRS in March 2008, we reclassified $5.8 million of income tax payable from current payable to long-term as of September 30, 2008.

In many cases, the uncertain tax positions are related to tax years that remain subject to examination by the relevant tax authorities. Federal and state statutes are open from 2003 through the present period. Hong Kong statutes are open from 2001, Luxembourg from 2003 and Mexico from 2001.

Debt Covenants

Our debt agreements require certain covenants including a minimum level of EBITDA and specified tangible net worth; and required interest coverage ratio and leverage ratio as discussed in Note 10 of the "Notes to Consolidated Financial Statements." If our results of operations erode and we are not able to obtain waivers from the lenders, the debt would be in default and callable by our lenders. In addition, due to cross-default provisions in our debt agreements, substantially all of our long-term debt would become due in full if any of the debt is in default. In anticipation of us not being able to meet the required covenants due to various reasons, we either negotiate for changes in the relative covenants or obtain an advance waiver or reclassify the relevant debt as current. We also believe that our lenders would provide waivers if necessary. However, our expectations of future operating results and continued compliance with other debt covenants cannot be assured and our lenders' actions are not controllable by us. If projections of future operating results are not achieved and the debt is placed in default, we would be required to reduce our expenses, including by curtailing operations, and to raise capital through the sale of assets, issuance of equity or otherwise, any of which could have a material adverse effect on our financial condition and results of operations. As of September 30, 2008, we were not in compliance with the EBITDA covenant and a waiver of the default was obtained on November 10, 2008.

New Accounting Pronouncements

For a description of recent accounting pronouncements including the respective expected dates of adoption and effects on results of operations and financial condition, see Note 11 of the "Notes to Consolidated Financial Statements."

Results of Operations

    The following table sets forth, for the periods indicated, certain items in
our consolidatedstatements of operations as a percentage of net sales:

                                              Three Months Ended             Nine Months Ended
                                                September 30,                  September 30,
                                             2008           2007           2008            2007
Net sales                                       73.4 %         89.6 %         85.4 %          92.4 %
Net sales to related party                      26.6           10.4           14.6             7.6
Total net sales                                100.0          100.0          100.0           100.0
Cost of sales                                   58.9           72.1           67.5            72.8
Cost of sales to related party                  24.5            9.5           13.3             6.9
Total cost of sales                             83.4           81.6           80.8            79.7
Gross profit                                    16.6           18.4           19.2            20.3
Selling and distribution expenses                4.4            5.3            5.5             5.7
General and administration expenses             12.1            8.7           13.3            10.1
Royalty expenses                                 0.7            0.6            0.8             0.6
Impairment charge                                  -              -            3.3               -
Terminated acquisition expenses                    -              -              -             1.1
Income (loss) from operations                   (0.6 )          3.8           (3.7 )           2.8
Interest expense                                (0.3 )         (1.8 )         (0.4 )          (2.1 )
Interest income                                  0.1            0.1            0.1             0.1
Interest in income (loss) of equity
  method investee                               (0.0 )          0.0            0.1             0.1
Other income                                     1.8            5.5            1.0             2.2
. . .